* Fed's inspector general criticizes failure to act
* Latest black eye for New York Fed bank supervisors
* Whale trade led to billions in losses at Wall Street bank (Adds recommendations, outside comment, secret examiner tapes)
By Jonathan Spicer and Michael Flaherty
NEW YORK/WASHINGTON, Oct 21 (Reuters) - The Federal Reserve's New York branch knew about risks JPMorgan Chase & Co was taking with its massive "London Whale" derivatives bets four years before they imploded, but it failed to act properly to head them off, the U.S. central bank's inspector general said.
The Fed's Office of Inspector General said on Tuesday one of the key flaws it uncovered in its probe of the 2008 transaction at the Wall Street bank was the New York Fed's over-reliance on certain personnel who left the supervisory team in 2011. That created a "significant loss of institutional knowledge" within the team assigned to inspect JPMorgan, the report said.
In what amounts to another recent black eye for the New York Fed's bank supervision unit, the report also noted that competing supervisory priorities and limited resources contributed to a failure to conduct key follow-up examinations.
The London Whale case emerged from JPMorgan's credit derivative trading losses in Europe in 2012, which were connected to its chief investment office (CIO) and ballooned to $6.2 billion by the end of that year. The bank was fined more than $1 billion by U.S. and British regulators for the loss, which sparked concerns in the U.S. Congress over lax Fed oversight in the throes of the financial crisis.
The inspector general's findings could stoke long-simmering concerns among Americans that federal regulators, the Fed in particular, are too deferential to Wall Street to head off another crisis and recession.
"It's a failure to coordinate, and it's frustrating," said Cornelius Hurley, a former assistant general counsel at the Fed's Board of Governors.
"It's nice to think that with the new set of players (since 2008) in Treasury and the New York Fed that we would get a re-examination of bank supervision, but I really don't see that happening without another financial crisis."
Perhaps the most damaging finding on Tuesday was evidence that the New York Fed became aware of risks in J.P. Morgan's CIO four years before the scandal broke. According to the report, the New York Fed identified the risks and planned two examinations of the bank's CIO office.
A team from the Washington-based Federal Reserve system also planned an examination in 2009, but the probes were not discussed with the Office of the Comptroller of the Currency, another U.S. agency responsible for bank supervision.
"As a result, there was a missed opportunity for the consolidated supervisor and the primary supervisor to discuss risks related to the CIO and to consider how to deploy the agencies' collective resources most effectively," the report said.
ANOTHER BLACK EYE
The Inspector General's office made 10 recommendations, including better cooperation with other regulators of complex banks, and better procedures for New York Fed staffers to escalate concerns and rethink their supervision in light of "emerging risks and changed circumstances" within banks.
The New York Fed has responded, the report added, by saying it is committed to improving supervision, and that it also has concerns about certain aspects of the report's findings. Because the concerns contain confidential supervisory information, the inspector general did not release them in its summary report.
The report is the latest image problem for the New York Fed, which acts as the central bank's eyes and ears on Wall Street. Last month, secretly-recorded tapes emerged that portrayed New York Fed examiners as hesitant to demand answers and changes from Goldman Sachs officials.
Hurley said that incident, which has prompted some lawmakers to demand public hearings, sounds similar to the problems outlined in Tuesday's report on the London Whale.
"The Inspector General is chronicling further anecdotes that indicate that regulators may not have been entirely diligent, and it's a shame," said Hurley, who is now director of the Center for Finance, Law & Policy at Boston University. "The regulators are as dependent on the banks for their survival as the banks are on the regulators," he said.
A New York Fed spokesman did not comment on Tuesday.
On Monday, William Dudley, a former Goldman Sachs partner who is now president of the New York Fed, delivered a tough speech aimed at the continued bad behavior exemplified by bankers, calling for an overhaul of compensation and for the firms to shrink if they cannot be managed effectively.
The inspector general's unabridged report is not publicly available. To read the summary report, click on: http://1.usa.gov/1uzrxo5
(Reporting by Jonathan Spicer and Michael Flaherty; Editing by Chizu Nomiyama, Meredith Mazzilli and Andrew Hay)